Once, not so long ago, big trading operations were perceived as perpetual revenue machines for the banks that ran them. But perceptions have changed almost as fast as the Fed could say "rate hike."
Following a horrific 1994, the risk of derivatives, currency, and bond trading has taken center stage. And to the discomfiture of major players, that picture apparently will not change anytime soon.
Driving home the point, Moody's Investors Service on Tuesday downgraded $5.4 billion worth of J.P. Morgan & Co. debt, citing concerns about the company's involvement in currency and sovereign debt markets. Moody's additionally lowered ratings on $140 million of debt issued by Bankers Trust New York Corp., citing the volatility of derivatives trading.
These demotions follow similar moves by Standard & Poor's Ratings Group - which has a negative outlook on Morgan debt - and by equity analysts. And they compound the challenge facing major trading institutions in 1995. Not only must they cope with all the financial and operational consequences of continued adverse market conditions, but they must also contend with heavy investor skepticism.
"We are assuming trading will rebound modestly in 1995, but last year's reversals taught us assumptions can be wildly wrong," said Diane Glossman, a banking analyst with Salomon Brothers Inc. "So long as investors feel low confidence, the earnings stream from trading will be given a low valuation."
The picture certainly wasn't this gloomy a few years back.
Aided by steady declines in interest rates and the value of the dollar, the six largest banking players parlayed currency and derivatives trades into $8 billion of revenues in 1993, up nearly 60% from 1992.
But the dark side of trading volatility burst into full view in 1994. Skyrocketing rates blew up derivatives-aided investing strategies. And the Mexican peso crisis has further roiled currency and sovereign debt markets.
In the fourth quarter alone, the six largest traders among U.S. banking institutions suffered a $1.64 billion, or 82%, decline in trading revenues. Capping a tumultuous 1994, the fourth-quarter rout profoundly affected investor views of money center banks, experts say.
On Wednesday, for example, Bankers Trust was trading at $tk, down tk% from a 52-week high of $84.25. Partly owing to trading weakness, Chase Manhattan Corp. was changing hands at $tk - an embarrassing discount to its Dec. 31 book value of $39.28.
The damage doesn't stop there. Citing concerns about trading revenue declines, Standard & Poor's Ratings Group last month downgraded $5.6 billion of Bankers Trust debt. And the agency still may follow Moody's lead in lowering debt ratings of J.P. Morgan & Co.
To be sure, not all trading institutions share the exposure of Bankers Trust and J.P. Morgan, which respectively derived 34.3% and 33.8% of total 1993 revenues from trading. The comparable ratio was 13% at Chemical Banking Corp.; 12.1% at Citicorp; 10.9% at Chase Manhattan Corp.; and 4.9% at BankAmerica Corp.
Still, analysts say trading can be a swing factor in earnings even at lesser-involved institutions, simply because of high fixed costs. Sophisticated teams and expensive computer systems can't be instantly cut back when revenues dip. And banks may limit chances to capitalize on the next upturn if they cut deeply when times are bad.
"One of the most significant risks in trading is operational risk,"said Art Soter, a banking analyst with Morgan Stanley & Co. "You are maintaining a very expensive infrastructure that occasionally may not generate revenues sufficient for its own support."
James P. Borden, a senior vice president and head of foreign exchange trading at Chase, said overhead is a less severe issue for units emphasizing transaction volumes over portfolio positions. He said Chase's global currency trading operation is built around client service, and that the unit is focused more on building transaction volume and market share than on cost-cutting.
By contrast, said Mr. Borden, overhead is a "significant management concern" for those institutions carrying highly leveraged inventories of currencies, derivatives, and sovereign bonds.
That brings up a sore point with analysts. They moan that money center banks don't publish enough information to permit a thorough evaluation of trading.
"The banks have been asked to provide line of business information and have been slow to respond," said Salomon's Ms. Glossman, who held out Bankers Trust as the lone exception. "We don't get details on personnel, product, system and incremental costs, so we are not in a position to say who is productive and who is not."
Limited to information about revenues only, Ms. Glossman said, investors have refrained from giving trading banks full credit when times are good - and have tended to overly penalize them when times are bad.
A logical question arises as to whether trading institutions should acknowledge investors' skittishness and simply scale back their trading operations.
Perhaps surprisingly, however, analysts rally in support of trading as a valuable long-term business. For one thing, said Morgan Stanley's Mr. Soter, banking laws limit the alternatives that sophisticated money center banks can explore. And the analyst said 1994 should not be viewed as the final word on trading.
"I am convinced that both the derivatives and the emerging markets trading businesses will come back strongly," said Mr. Soter. "The case for derivatives as risk management tools is quite compelling, and the problems in emerging markets eventually will work themselves out."
Even if trading's convalescence is protracted, some analysts say, certain money center banks still deserve more recognition than they are getting on Wall Street. For example, First Manhattan Corp. analyst Raimundo Archibold Jr. recently affirmed his "buy" rating on Chemical.
"Chemical has a valuable franchise, and - almost no matter what happens with trading - it is undervalued," he said.
There is no denying that there are rocks on the road ahead, however.
For one thing, trading banks haven't delivered on former assertions they can do well in any kind of market, said Tanya Azarchs, director of financial institutions research at Standard & Poor's Ratings Group.
"It now appears that the trend of rising domestic rates is contributing heavily to the poor trading environment," said Ms. Azarchs. "That being the case, we may be in for a longer spell of trading weakness."
In the meantime, Ms. Azarchs added, trading banks will remain uncomfortably in the limelight.
Rumors questioning the health of Bankers Trust were rampant when its derivatives troubles surfaced last year, Ms. Azarchs noted, and Citicorp briefly became an object of concern when the Mexican peso collapsed.
Although no sort of crisis is in the offing, Ms. Azarchs said, such episodes serve as reminders that trading volatility can affect the cost and availability of short-term funds.
That adds up to an uncomfortable position. "Not only will money center banks have difficulty with trading, but they will be lightning rods for the issues surrounding it," Ms. Azarchs said.